294 / What are the tax consequences for death proceeds of a life insurance policy purchased by an S corporation?

Where an S corporation is beneficiary of a policy and death proceeds are received as tax-exempt income, each stockholder’s pro rata share of the proceeds is tax-exempt to him or her and the basis of each stockholder’s stock is increased by his or her share of the tax-exempt proceeds.¹ An S corporation’s delay in receiving death proceeds that will be used to purchase a deceased shareholder’s shares will result in an increase in the basis of each shareholder’s shares, not just the shares of the surviving shareholders.²

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Planning Point: There are special notice, consent, and reporting requirements applicable to employer owned policies entered into after August 17, 2006 ( Q 8776). If these requirements are not met, a portion of the death benefit becomes taxable income.

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If a corporation is neither owner nor beneficiary, proceeds of a policy paid for by the corporation should be tax-free to the beneficiary as life insurance proceeds ( Q 63 to Q 79). The transfer for value rule has an impact on the taxation of death proceeds ( Q 279). If a corporation owns a policy but is not the beneficiary, the characterization of the proceeds is not entirely clear ( Q 291). If they are treated as a distribution of profits, that is, as dividends in the case of a regular C corporation, they would be taxed as a return of basis, capital gain, or dividends. If proceeds paid to a beneficiary of a policy owned by a corporation are treated as corporate distributions, they also should be treated as tax-free proceeds to the corporation that increase each shareholder’s basis pro rata.